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Lucian Bebchuk says there's no need for the government to protect bondholders
in a financial crisis:
Governments must not bail out bondholders, by Lucian Bebchuk, Commentary,
Project Syndicate: A year after the United States government allowed …
Lehman Brothers to fail but then bailed out AIG,… a key question remains: when
and how should authorities rescue financial institutions?
It is now widely expected that, when a financial institution is deemed “too big
to fail”, governments will intervene if it gets into trouble. But how far should
such interventions go? In contrast to the recent rash of bailouts,… the
government’s safety net should never be extended to include the bondholders of
In the past, government bailouts have typically protected all contributors of
capital of a rescued bank other than shareholders. Shareholders were often
required to suffer losses or were even wiped out, but bondholders were generally
saved by the government’s infusion of cash. … Bondholders were saved because
governments generally chose to infuse cash in exchange for common or preferred
shares – which are subordinate to bondholders’ claims – or to improve balance
sheets by buying or guaranteeing the value of assets.
A government may wish to bail out a financial institution and provide protection
to its creditors for two reasons. First,… a protective government umbrella
might be necessary to prevent inefficient “runs” on the institution’s assets
that could trigger similar runs at other institutions.
Second, most small creditors are … unable to monitor and study the financial
institution’s situation when agreeing to do business with it. To enable small
creditors to use the financial system, it might be efficient for the government
to guarantee (explicitly or implicitly) their claims.
But, while these considerations provide a basis for providing full protection to
depositors and other depositor-like creditors…, they do not justify extending
such protection to bondholders.
Unlike depositors, bondholders generally are not free to withdraw their capital
on short notice. They are paid at a contractually specified time, which may be
years away. Thus, if a financial firm appears to have difficulties, its
bondholders cannot stage a run on its assets and how these bondholders fare
cannot be expected to trigger runs by bondholders in other companies.
Moreover, when providing their capital to a financial firm, bondholders can
generally be expected to obtain contractual terms that reflect the risks they
face. Indeed, the need to compensate bondholders for risks could provide market
discipline: when financial firms operate in ways that can be expected to produce
increased risks down the road, they should expect to “pay” with, say, higher
interest rates or tighter conditions.
But this source of market discipline would cease to work if the government’s
protective umbrella were perceived to extend to bondholders… Thus, when a
large financial firm runs into problems that require a government bailout, the
government should be prepared to provide a safety net to depositors and
depositor-like creditors, but … the government should not provide funds
(directly or indirectly) to increase the cushion available to bondholders.
Rather, bonds should be at least partly converted into equity capital, and any
infusion of new capital by the government should be in exchange for securities
that are senior to those of existing bondholders.
Governments should … make their commitment to this approach clear in advance. … This would not only eliminate some of the unnecessary costs of government
bailouts, but would also reduce their incidence.
Anything that imposes the costs of the bailout on the people
participating in the markets rather than on taxpayers without
compromising the ability to protect the financial system (or, as claimed above, even enhancing the protective shield) is ok with me.